Bank competition and financial stability

This report examines the interplay between banking competition and financial stability, taking into account the experiences of the recent global crisis and the policy response to date.

Policy makers are faced with striking a balance between sometimes conflicting objectives. Banks need to have sufficient capital and be large and diversified enough to absorb major shocks, whilst remaining sufficiently competitive to provide consumers with reasonably-priced services.

Pre-crisis financial deregulation allowed banks to change their business models in response to competition in a way that has proven negative for financial stability.

The policy response to the global financial crisis to date has not adequately addressed some of the fundamental problems affecting the banking sector and thus the risks to financial stability.

Part 1: Competition in retail banking and financial stabilityStudies exploring the complex interactions between competition and stability in retail and commercial banking come to the ambiguous conclusion that competition can be both good and bad for stability. Policy measures that strike an acceptable balance remain elusive.

Part 2: Competition in derivative markets and financial stabilityToday, the large banks that encompass the global derivatives business combine retail and commercial banking with investment bank activities. Product innovation utilising derivatives and gambling in high-risk trades has become a key driver of profitability within banks but this leaves them exposed to huge risks which in turn pose a threat to global financial stability. Policy makers urgently need to address this issue.

Part 3: Bank competition and government guarantees Using government guarantees to avoid systemic fallout from the crisis distorted competition between banks and further reinforced the perception that systematically important banks enjoy implicit guarantees. To reduce this perception, policy reforms must include provisions for the orderly failure of financial institutions, whatever their size, level of interconnectivity and complexity.